A Century of Purchasing Power Parity Confirmed: The Role of Nonlinearity

Kim, Hyeongwoo and Moh, Young-Kyu (2009): A Century of Purchasing Power Parity Confirmed: The Role of Nonlinearity.

Abstract

Taylor (2002) claims that Purchasing Power Parity (PPP) has held over the 20th century based on strong evidence of stationarity for century-long real exchange rates for 20 countries. Lopez et al. (2005), however, found much weaker evidence of PPP with alternative lag selection methods. We reevaluate Taylor’s claim by implementing a recently developed nonlinear unit root test by Park and Shintani (2005). We find strong evidence of nonlinear mean-reversion in real exchange rates that confirms Taylor’s claim. We also find a possible misspecification problem in using the ESTAR model that may not be detected with Taylor-approximation based tests.

• Item Type: MPRA Paper
• Language: English
• Keywords: Purchasing Power Parity; Transition Autoregressive Process; inf-t Unit Root Test
• Subjects: C - Mathematical and Quantitative Methods > C2 - Single Equation Models ; Single Variables > C22 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes; F - International Economics > F3 - International Finance > F31 - Foreign Exchange

References

Bec, Frederic, Melika Ben Salem, and Marine Carrasco, 2004, Test for unit-root asymmetric threshold specification with an application to the purchasing power parity relationship, Journal of Business and Economic Statistics 22, 382—395.

Caner, Mehmet, and Bruce E. Hansen, 2001, Threshold autoregression with a unit root, Econometrica 69, 1555—1596.

Crucini, Mario J. and Mototsugu Shintani, 2007, Persistence in law-of-one-price deviations: Evidence from micro-data, Journal of Monetary Economics.

Dumas, Bernard, 1992, Dynamic equilibrium and the real exchange rate in a spatially separated world, Review of Financial Studies 5, 153—180.

Granger, Clive W.J., and Timo Teräsvirta, 1993, Modelling Nonlinear Economic Relationships (Oxford University Press: Oxford).

Hall, Alastair, 1994, Testing for a unit root in time series with pretest data-based model selection, Journal of Business and Economic Statistics 12, 461—470.

Hansen, Bruce E., 1999, The grid bootstrap and the autoregressive model, Review of Economics and Statistics 81, 594—607.

Harris, Richard Ian, 1992, Testing for unit roots using the augmented dickey-fuller test: Some issues relating to the size, power and the lag structure of the test, Economics Letters 38, 381—386.

Kapetanios, George, Yongcheol Shin, and Andy Snell, 2003, Testing for a unit root in the nonlinear star framework, Journal of Econometrics 112, 359—379.

Kapetaniosa, George, and Yongcheol Shin, 2003, Unit root tests in three-regime setar models, Manuscript, University of Edinburgh.

Lopez, Claude, Christian Murray, and David H. Papell, 2005, State of the art unit root tests and purchasing power parity, Journal of Money, Credit, and Banking 37, 361—369.

Michael, Panos, A. Robert Nobay, and David A. Peel, 1997, Transaction costs and nonlinear adjustment in real exchange rates: An empirical investigation, Journal of Political Economy 105, 862—879.

Ng, Serena, and Pierre Perron, 2001, Lag length selection and the construction of unit root tests with good size and power, Econometrica 69, 1519—1554.

Obstfeld, Maurice, and Alan M. Taylor, 1997, Nonlinear aspects of goods-market arbitrage and adjustment: Heckscher’s commodity points revisited, Journal of the Japanese and International Economics 11, 441—479.

Park, Joon Y., and Mototsugu Shintani, 2005, Testing for a unit root against transitional autoregressive models, Working Paper No. 05-W10, Vanderbilt University.

Pippenger, Michael K., and Gregory E. Goering, 1993, A note on the empirical power of unit root tests under threshold processes, Oxford Bulletin of Economics and Statistics 55, 473—481.

Seo, Myung Hwan, 2006, Unit root test in a threshold autoregression: Asymptotic theory and residual-based block bootstrap, Econometric Theory, forthcoming.

Sercu, Piet, Raman Uppal, and Cynthia Van Hulle, 1995, The exchange rate in the presence of transactions costs: Implications for tests of purchasing power parity, Journal of Finance 50, 1309—1319.

Taylor, Alan M., 2001, Potential pitfalls for the purchasing-power-parity puzzle? sampling and specification biases in mean-reversion tests of the law of one price, Econometrica 69, 473—498.

Taylor, Alan M., 2002, A century of purchasing power parity, Review of Economics and Statistics 84, 139—150.

Taylor, Mark P., David A. Peel, and Lucio Sarno, 2001, Nonlinear mean-reversion in real exchange rates: Toward a solution to the purchasing power parity puzzles, International Economic Review 42, 1015—1042.

van Dijk, Dick, Timo Teräsvirta, and Philip Hans Franses, 2002, Smooth transition autoregressive models: A survey of recent developments, Econometric Reviews 21, 1—47.